The Impact of Today’s Rising Interest Rates on the Real Estate Market

This year ushers in an economic period of uncertainty powered by the aggressive monetary tightening policies unveiled by the Federal Reserve. Interest rates have steadily climbed and are expected to have wide-ranging implications in the real estate sector. This upward trend in interest rates has far-reaching consequences for buyers, sellers, and investors alike. Understanding the potential impact of rising interest rates on real estate is crucial for navigating the complexities of today's market. 

Table of Contents

Rising Interest Rates and the Housing Market

Why Are Mortgage Rates Currently High?

How Do Interest Rates Affect Property Values?

Key Impacts of Rising Interest Rates on the Real Estate Market

• Impact on Homebuyer Demand and Affordability
• Impact on Property Prices
• Mortgage Applications and Refinancing Trends
• Rental Market and Affordability Crisis

Does High Interest Rate Impact Commercial Property?

Rising Interest Rates and Real Estate Investing

Tips for Investors During a High-Interest Rate Environment

The Bottom Line

FAQs

Rising Interest Rates and the Housing Market

The upward trajectory of interest rates has had a profound impact on the housing market. In fact, this was well expected in October 2023, as the 30-year mortgage rate leaped to 6.54%, breaking many months of decline. With the cost of borrowing increases, buyers' behaviors have taken a foretold hit: home sales are slowing down.

According to the U.S. Bank Asset Management, higher interest rates have scared off buyers because the increased financial burden coming with mortgages has gradually made owning a home more unaffordable. For all these reasons, September 2023 saw the fall in the sale of existing homes to one of its lowest annualized rates on record books at 3.84 million. This can be attributed to factors such as an unprecedentedly low inventory of homes available in the market. For this reason, many existing home owners who have secured mortgages at much lower rates of about 3.5% have opted to stay in their homes rather than sell and increase their monthly mortgage payments. 

Why Are Mortgage Rates Currently High?

Mortgage interest rates are currently elevated due to economic and policy factors. One of the strong catalysts for higher mortgage rates has been rising bond yields, particularly those yields on 10-year Treasury bond rates. Certainly, each time bond yields rise, mortgage interest rates seem to follow suit.

The second reason is the wider spread in the contribution of higher lending rates to mortgages between the 10-year bond rate and mortgage rates. This “mortgage spread” reflects the additional risk premium demanded by investors for mortgage-backed securities. A wider spread reflects a lack of demand for those securities, which could mean higher mortgage rates. It has narrowed from recent times but also remains way higher compared to the levels during the early part of 2022, when interest rate trends upwards.

How Do Interest Rates Affect Property Values?

Another direct impact of interest rates on property values is through mortgage costs.

Generally, when interest rates go up, so do mortgage rates, making monthly payments more expensive. This shrinks the pool of likely buyers who can afford to purchase a house. That decreased demand for homes translates into slower increases in property prices or even a decline, since selling can often be possible only by shaving the price in a way that would attract buyers capable of paying an increased financing cost.

Indirectly, the effect of increasing rates on property values is obtained by way of effects on the broader economy. A high rate ultimately means slower economic growth and reduced consumer spending. Thus, it pulls its weight on reducing housing demand levels. Finally, higher rates make investment in real estate less attractive; investors may look elsewhere for better yields, reducing demand for a property and therefore depressing values. 

Key Impacts of Rising Interest Rates on the Real Estate Market

Let’s discuss the key impact of rising interest rates on real estate market.

Impact on Homebuyer Demand and Housing Affordability

Higher interest rates have a very strong impact on the demand for housing, particularly on the affordability concerns of homebuyers, because higher borrowing costs are tantamount to increasing the cost of homeownership. With increased mortgage rates, the monthly payment rate increases as well, shrinking the pool of potential buyers who can qualify for a loan. In addition, the debt-to-income ratio that lenders typically require keeps loan availability at a minimum for most potential homebuyers. This reduced buyer qualification is putting a damper on housing demand.

Impact on Property Prices

Typically, high interest rates contribute to property price stabilization or even decline, as decreased demand puts downward pressure on prices. However, the effects can vary across market segments. In urban areas, where housing prices are already more expensive, rising rates may lead to price stagnation or slight declines as affordability worsens. Rural areas, where property prices are generally lower, may see the least immediate impact but could still face slowdowns in price growth as buyers exercise more caution in committing to mortgages.

Rental Market and Affordability Crisis

While high interest rates might keep potential buyers out of the market, many of them resort to renting. It has contributed to the long-pressing affordability challenges in the rental market, with higher demand pushing rents upward, especially in those urban areas that are already short of rental housing. Renters are going to have to pay more, thus creating new problems in searching out options for finding affordable properties or housing.

Does High Interest Rate Impact Commercial Property?

Higher interest rates significantly affect the commercial real estate (CRE) sector, particularly by impacting capitalization rates, leasing demand, and investor interest. Capitalization rates, which measure property value based on income generation, often rise with interest rates to maintain competitive returns. This increase in cap rates can reduce property values, especially in office and retail spaces, where investor demand is already softening.

The near-term outlook for CRE is increasingly uncertain as rising interest rates reduce transaction activity, potentially triggering distress in certain property types. According to GreenStreet, commercial real estate transaction volumes are down almost 70%, which makes it really tough for investors to tell what properties are actually worth in a cooling market.

Rising Interest Rates and Real Estate Investing

In a high-interest-rate environment, investment strategies in real estate are usually adjusted to protect returns or reduce risks. The more common changes involve high-yield property and cash-flow-positive assets that can continue supporting real estate investor income at increased costs of borrowing. Properties with consistent cash flow streams, such as multi-family rentals or established commercial spaces with long-term leases, become favorable since operating costs can be covered and returns are earned without heavy dependence on market appreciation.

For real estate investment trusts (REITs), rising interest rates pose unique challenges. REITs typically rely on debt financing to acquire and manage properties, so higher rates increase their cost of capital and reduce the profitability of new acquisitions. This may make it difficult to keep up with attractive dividends to investors since a larger portion goes to debt servicing. This demand resilience may make the industrial and multi-family-focused REITs outshine those focused on office or retail. Real estate investors have to be selective in determining which assets and REITs are better positioned to navigate the economic changes to continuously create value. 

Tips for Investors During a High-Interest Rate Environment

Making an investment in real estate when the interest rates are high involves a few strategic readjustments in balancing risk and return. Here are several tips to help investors navigate the impact of rising interest rates on real estate market conditions effectively:

1. Prioritize cash flow
2. Consider shorter-term alternative financing options
3. Focus on value-add opportunities
4. Evaluate REIT investments carefully
5. Keep an eye on market cycles

It is by choice of investments and modifications in strategies that investors can overcome the unfavorable conditions brought in by high interest rate environments, preserving potential for growth and maintaining financial stability in their portfolios.

The Bottom Line

The impact of rising interest rates on real estate is undeniable. It affects everything from demand for properties to home buying and property valuation. While higher borrowing costs decrease affordability of homes and slow transaction volumes, a number of opportunities can be grasped by careful strategy adjustments. Informed knowledge about perceivable market trends will ready real estate investors to make necessary changes to strategies and sail through this changeable environment, ensuring that investments become solid even in turbulent economic times. 

FAQs

What are interest rates and how are they determined?

Interest rates reflect the cost of money and are expressed as a percentage of money borrowed. Interest rates are achieved through policy decisions among central banks and, for instance, in the United States, through the Federal Reserve. Other factors that contribute to changing interest rates include general economic conditions, demand in credit markets, and the risk of lending.

Are high interest rates bad for the housing market?

High interest rates depress the growth rate in the housing market since it reduces house buyer and/or consumer affordability and demand. Since higher interest rate costs increase mortgage costs, fewer transactions and lower price growth may appear, even price declines in some areas.

Is it worth investing in real estate with high interest rates?

While interest rates are high, real estate investment can still be rewarding. The approach, however, needs to be strategic. The main focus of the investor has to be on properties that bring positive cash flow, value-add opportunities, and sectors that can resist the changes caused by the market. It is very important to consider the higher cost of financing and manage one's expectation of return accordingly.

What types of real estate are less affected by rising interest rates?

Multi-family residences, industrial properties, and some commercial types of property, such as warehouses or data centers, could be more resilient to hikes in rates. Those are the sectors with the highest occupancy rates and more stable levels of income that cushion them against an increase in borrowing costs.